Derivatives as a double-edged sword

Updated: May 18 2007, 05:30am hrs

On paper, it can never be proven whether derivatives have rewarded investors or slain them. My sense is that, by and large, they have drawn blood on the street. However, is the instrument at fault It would not be fair to make this allegation. For, the fate of an investor depends on just how s/he deploys derivatives to achieve an objective.

Derivatives, functionally defined as financial instruments that derive their value from one or more underlying asset/s, can be broadly divided into two classes: futures and options.

Futures, in essence, are contractual obligations to buy something at a future date at a pre-fixed price. In futures trading, the whole can be said to be greater than the sum of parts. Let me explain.

Generally, futures are bought by those who want to leverage their exposure on their given capital. Its margin play, for all practical purposes, since a stock future may be bought for less money than the actual stock. People typically use futures to bet on a stocks rise in price over the contractual period. Now, if the market price of a stock does indeed rise in their favour, they simply square off and book profits.

Otherwise, players often prefer to carry their position forward to the following monthin the expectation of their forecast outcome showing up later. But sticking to ones bet can prove expensive. Few lay investors are aware that if you carry a futures position forward from one month to another, you possibly pay a charge of 15-18% (annualised) for this, plus brokerage charges and securities transaction tax. That adds up to about 20% in all. This means that even if a stock appreciates by 20% in a year, you will not make a profitassuming the price-earnings (PE) ratio does not improve; only if the earnings-per-share (EPS) of the stock you hold comfortably outpaces the stock price will you make any money. To diversify risk, you may want to buy multiple stock futures, but you run into the same cost problem unless there is a market-wide PE re-rating.

Under such circumstances, a better strategy is to buy Nifty or Sensex futures (the whole, therefore, rather than the sum of parts). This has several advantages. Notably, the rollover charges are lower, at just 1-2% per annum. These also offer a liquid platform for hedging and short-selling.

Now, if you take a Nifty position and hold it for the next five years, and even if the Nifty remains at the same level even after five years, you lose practically nothing on Nifty futures rollovers (unlike in specific stocks, which can cost plenty).

People who buy put options to hedge their portfolio in the run-up the Budget, corporate results and so on, often end up with losses. They do not realise that the premium on options is not less than 3.5% per month (42% annualised). Similarly, the regular purchase of call options is statistically non-profitable, because you are paying 3.5% per month, and the Sensex EPS growth on a consistent basis is around 15% annually

Is there another way to keep rollover costs low Yes, there is. There is an anomaly in the Indian futures market. Altogether, there are 180 future-traded stocks, of which some 30 can be defined as large cap, and thus highly liquid. The rollover charges for these are low (otherwise, the difference between Nifty and Nifty constituent stocks would create an arbitrage opportunity), and you could pick from among these. However, the whole is a lot easier to track.

Speaking of which, people in my observation also like to short index futures whenever they expect a market correction. Again, if the market declines, they simply square off and book profits. But if the market rallies instead, they tend to carry forward the position, expecting the market to correct in due course. Giving up on ones starting assumption is always painful (and this human trait, be warned, helps a lot of others make money). They fail to realise that with each passing month, the EPS of the index rises (at 13-15% per annum, currently). Thus, even if the PE of the index does not improve, by virtue of higher EPS figures alone, the market next year will be 15% above their selling price. Going short and staying short is a losing game. Markets do have corrections every now and then, but over time, they tend to rise. So, my advice: go long.

While a futures contract represents an obligation to buy/sell a stock on a future date, an option represents a right to exercise a buy/sell deal. You can choose to either put a stock (sell at a pre-set price) or call it (buy it). These rights are not cheap, and realistically speaking, only an expert can manage to make money through options.

Lay investors who buy put options to hedge their portfolio in the run-up to the Budget, corporate results and so on, often end up with losses. They do not realise that the premium on options is not less than 3.5% per month (or as much as 42% annualised). Similarly, the regular purchase of call options is statistically non-profitable, because you are paying 3.5% per month, and the Sensex EPS growth on a consistent basis is around 15% annually. Options should be best left to arbitrageurs who have scientific tools to exploit relevant opportunities.

While futures and options seem useful, remember that their practical application demands a high degree of skill and sophistication. To conclude, you may try using derivatives on the battlefield (the stock market), but as with any double-edged sword, you must know how exactly to wield the weapon.

The author handles the derivatives practice at Angel Broking. These are his personal views